Strategies to counter the domino effect

When the Ever Given blocked the Suez Canal for days on end in March 2021, the pictures beamed around the world had already gone beyond the “writing on the wall”. They were no longer merely a portend of impending doom. Having run aground on the embankment and swung round to block the narrow shipping channel, the gigantic container vessel caused hundreds of cargo ships to back up on either side. It took weeks to ease the congestion.

This event presented a vivid illustration of what had threatened a year earlier when the coronavirus put the world into lockdown. The global economy is intricately interwoven: In extreme situations, even minimal disruptions can paralyze entire sectors of production if supply lines falter. Up to now, the economic gears have creaked and groaned in this way only to a limited extent. Bottlenecks in materials and input products have occurred only for a short period. The coronavirus pandemic, however, and now the Ukraine war have made it clear to the public at large just how vulnerable the economy really is. Moreover, these events have given public visibility to a concept hitherto familiar only to economists themselves: the concept of global supply chains.

In very simple terms, a global supply chain can be likened to an assembly line along which all required materials and input products are delivered from the farthest corners of the Earth to the manufacturer, who then puts them together to make refrigerators, cars or computers. If only a single link in this chain is missing and cannot be replaced or substituted, production as a whole grinds to a halt.

Let us stress again that this is an oversimplified image. Given that many industries today add value on a global basis, and that interdependencies have become vastly more complex over the years, supply chains have long been an issue in economic research: “For many years now we have been thinking about the question of how free trade agreements alter global value chains, and we use models to seek to quantify the impacts,” says Lisandra Flach, outlining one of the main focuses of her work.

Flach is Professor of Economics at LMU and Director of the ifo Center for International Economics in Munich. “Even before the pandemic, there were repeated disruptions to supply chains – after natural disasters, for example, or due to geopolitical events,” she explains. “The difference this time was that every country in the world was affected by the pandemic, which exacerbated the problems.”

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Complexity adds to the risks

In today’s globalized economy, all kinds of different manufacturers around the globe are often involved in making just a single product. When a car is manufactured, for example, hundreds of different parts must be brought together in a complex process that places heavy logistical demands. The trick is to ensure that the individual components from around the world all reach the production line – some of them after weeks of traveling by sea, rail and road – at just the right time to be assembled within a tight time slot.

Under the constant cost pressure imposed by globalization, many countries have introduced lean production processes and trimmed their stocks to a minimum. These stocks are replenished “just in time” with input and intermediate products sourced on the global market from the lowest-cost providers, who in turn can exert cost pressures of their own by producing in large volumes. “Supply chains have become ever more complex as a result,” Flach says. “To manufacture one end product, intermediate products today sometimes cross several national borders, which adds to the vulnerability.”

A number of factors have favored this development: One is that technological advances have facilitated seamless connectivity between companies all over the world. Another is that international treaties have made global trade more predictable and less expensive. They have done this by making it easier to enforce contracts and, thanks to lower customs duties and non-tariff hurdles, by cutting trading costs. Lastly, structural reforms have made it easier for companies to invest abroad.

Thanks to this technological, institutional and political progress, the ever greater subdivision of production processes has given a tremendous boost to international trade in input and intermediate products. Especially since the end of the 1980s, emerging economies too have benefited from this development by becoming more deeply integrated in global supply chains. There is a serious downside, however: A more atomized system may become more vulnerable to negative shocks. Worse still, for certain products there are only a handful of highly specialized suppliers – or only a single one in extreme cases.

Companies struggling with the shortage of raw materials and input products

All of us felt the consequences during the pandemic. In its acute phase, factories in Germany had to close their doors even as demand for a series of products increased. Under lockdown, consumers were no longer able to eat out, travel or make use of other contact-intensive services. They responded by spending more money on computers and other electronic devices that allowed them to work, learn and play from home.

Yet global supply chains are not designed to cope with this kind of shift. The Munich scientists regularly ask businesses whether they are battling restrictions on production due to shortages of raw materials and/or input products. “At the start of the second winter of corona,” Flach reports, “roughly four out of five manufacturing companies said that yes, they were. The ifo monthly survey indicated that roughly 82% of manufacturing firms experienced material shortages – a new record.”

The shortage of semiconductors has attracted greater attention and is still making itself felt today. Silicon (typically from China) used to produce wafers in Taiwan and fashioned into chips on the West Coast in the US was a chain that stopped functioning, and that has brought automobile assembly lines grinding to a halt worldwide.

But it has also severely curtailed the production of many other high-tech goods, from smartphones to simple household appliances. Initial hopes that this was only a temporary bottleneck turned out to be illusory. Why? Because on top of the restrictions imposed by the pandemic, the geopolitical convulsions of 2022 have now also thrown another wrench into the elaborately synchronized gears of the world’s supply chains.

Semiconductor bottlenecks regarded as “exceptionally critical”

“Russia’s war against Ukraine has forced global supply chains to deal with a second shock in the wake of corona, this time associated with increased geopolitical risks,” Lisandra Flach says. Besides triggering a humanitarian disaster, the war is also hindering the flow of goods. Many trade links between Western Europe and China pass through Ukraine and Belarus as transit countries. And because of the sanctions imposed on Russia, some rail connections between China and Europe that pass through Russian territory have been halted.

In addition to these developments, there are fears that the perennial conflict between China and Taiwan could escalate further and place an even greater strain on global supply chains. Chip manufacturers warn that Europe, for example, is more heavily dependent on semiconductors from Taiwan than on energy from Russia. If the flow of semiconductors from Taiwan were to dry up completely, that would have profound implications for all aspects of the economy, all over the world.

Political and business circles are certainly alarmed, and not only about the semiconductor crisis: “Imported input products play a pivotal part in Germany’s export industry. 27% of German exporters are also importers, and these firms account for more than 95% of all German trade,” is the message conveyed by a study in which Lisandra Flach played a seminal role. Inputs, the professor says, are thus an “essential element in Germany’s ability to compete”.

But what strategies is the business community pursuing to tackle these challenges? “We regularly ask industrial firms on their business conditions. Last year we asked whether firms plan to change their sourcing strategy, and nearly 40 percent already answered they had plans along these lines,” Flach reports.

A further survey published in mid-2022 by researchers close to Flach found that nine out of ten companies have now taken action to modify their sourcing strategy since the beginning of the pandemic. There are several options to make supply chains resilient, i.e. able to keep working even in the event of shocks. They include diversifying the suppliers and running up larger inventories in order to better cope with temporary supply bottlenecks.

US Finance Minister Janet Yellen goes a step further and, in response to embargos and [economic] blackmail, demands that trading partners be split into friends and foes. Lisandra Flach is not so sure: “Our analysis shows that the consequences of breaking completely with autocratic states would, in the short term, come at a high price for the German economy.” If costs were to decrease again in the long term, she adds, these consequences should not be underestimated.

She and her colleagues have done the math: “For us, a trade war with China could be six times more expensive than Brexit,” she warns. Even if it were possible to swap supplies from autocratic states for deliveries from countries that share similar values to our own, that would still not guarantee a reliable supply of raw materials and input products: “Even in supposedly safe countries, environmental risks and cyber-risks can interrupt supply chains at any time,” the economist states.

Reshoring would negatively affect our prosperity

So, should we indeed strive for greater autonomy and bring the manufacture of input products back onshore? Not a good idea, in Flach’s opinion: “Our complex supply relationships give us substantial efficiency gains. Reshoring would negatively affect our prosperity. It would erode our ability to compete and, according to our quantitative analyses, shave around ten percent off our GDP in the long run.” Even nearshoring production to neighboring countries would still reduce economic performance by a good four percent.

For this reason, the economist is skeptical of government intervention in the global supply chains, as such measures are associated with high costs. “It might make sense in exceptional cases and for critical goods,” she concedes. Even then, though, Flach sees the need to clarify what makes a product critical enough to warrant such intervention.

Trade-off between resilience and costs

Lisandra Flach believes it is far more important “for the government to create a clear framework within which companies can improve the geographic diversity of their supply chains”. This is the lesson that must be learned from recent crises, she insists: Unilateral dependencies – especially on politically unstable countries – must be avoided, as is abundantly clear from the current wrangling over substitutes for Russian gas. The conflict in Ukraine has had the effect of dividing political alliances even more clearly into regional trading blocks. “We must eliminate weak links in the supply chains, especially where unilateral dependencies exist – such as the ones we see regarding energy and raw materials for key technologies,” is Flach’s advice.

Munich academics only recently took a close look at the extent of such dependencies. The European Union defines 23 raw materials as crucial to the production of key technologies. From this list, Lisandra Flach and her team identified nine raw materials for which the situation is especially tight. A “critical dependency” exists for substances such as cobalt, boron, silicon, graphite and rare earths: The number of suppliers is small, the market heavily concentrated, and a number of key technologies simply cannot do without these materials.

Political decision-makers and business leaders thus face the daunting challenge of weighing their desire for more resilient supply chains against cost considerations. Alternative suppliers and/or larger inventories do not come free of charge. The optimal choice will therefore depend on country-specific circumstances and risk tolerance. Surveys conducted by the Munich academics indicate that large companies tend to opt for greater procurement diversification, while smaller firms generally look to increase their stocks.

Lisandra Flach calls on policymakers to “put reliable foreign trade conditions in place for the business community”. In addition, she believes Germany and the EU should push for a reform of the World Trade Organization (WTO) in order to benefit from the “insurance role played by international trade”. How effective all these countermeasures will be in the face of a dramatically changed global situation will be seen not least by what our consumer economy is indeed able to deliver in the future.

Prof. Dr. Lisandra Flach is Professor of Economics at LMU, with a strong focus on the economics of globalization. She is also Director of the ifo Center for International Economics at the ifo Institute in Munich. Born in 1983, she studied economics at the Universidade do Estado de Santa Catarina and the Universidade Federal de Santa Catarina, both in Florianopolis, Brazil. She earned her doctorate at the University of Mannheim before moving to LMU in 2012. She has held the Chair of Economics since 2020.

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